Portfolio Diversification, Leverage, and Financial Contagion

Abstract

The Mexican peso crisis that began in late 1994 was an adverse shock not just to Mexico, but also to several Latin American countries and to other countries around the world. Likewise, the financial consequences of the collapse of the Thai baht in 1997 and the unilateral debt restructuring by Russia in 1998 were far-reaching and created turbulence in even the largest and most developed capital markets in the world. These recent episodes of market turbulence have generated interest in why and how local financial events can affect market dynamics and cause turbulence in other countries’ financial markets. Several models of financial contagion have been developed that can explain why investors might sell many risky assets when an adverse shock affects just one asset. These models associate financial contagion with market imperfections — most often asymmetric information.

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This chapter is an edited version of IMF Working Pager 99/136 and is reprinted here with the permission of the International Monetary Fund. An abridged version is to be published in IMF Staff Papers. The authors thank Burkhard Drees, Gaston Gelos, Charlie Kramer, and Holger Wolf (our discussant) for useful comments. The views expressed in the paper do not necessarily reflect those of the International Monetary Fund.